Costs that can be directly traced or linked to a specific cost unit are called prime costs. The prime costs are also known as direct costs.
Prime costs = Direct material cost + Direct labour cost + Direct expenses
This concept is used to determine contribution that a cost unit (product or service) generates. It can help in pricing decisions as well. A business would ideally set the price of its products well above their prime costs in order to generate enough contribution to cover indirect costs and to generate profits.
Every business aims to maximize its profits and for that, it needs to minimize its costs. Total costs are broken down into different components for microscopic view and analysis. The concept of prime cost enables the management of a business to have a detailed look into the direct costs. Idea is to find any room for cost cutting so that the product or service becomes more profitable.
Example of prime cost
Prime costs of a furniture manufacturer may include:
- direct material costs such as wood, plastic etc.
- direct labor costs such as wages of persons making furniture from wood and plastic.
- direct expense such as royalty paid for each item produced to another company whose design or brand is used.
Prime cost as a part of total cost
To sell a good or a service, a business has to incur some costs which include both:
- prime costs (direct costs), and
- overheads (indirect costs)
Here is a proforma cost card which shows the total costs of a product. Prime cost is highlighted to get a better idea where it fits in the full cost calculation of a product.